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Sector Rotation as an Investment Strategy

What is sector rotation?  Sector rotation has been used by professional investors for years. It involves moving or rotating from sector to sector within the S&P 500. A sector is a particular industry segment of the economy as represented in the S&P 500 index. Sam Stovall, Chief Investment Strategist for Standard and Poor’s, wrote a seminal study on the benefits of sector rotation (S&P’s Guide to Sector Rotation). Mr. Stovall listed 9 industries or sectors: Technology, Basic Materials, Staples, Financials, Energy, Utilities, Cyclicals, Industrials, and Healthcare. Each of these sectors benefits during different times in a normal peak to trough economic cycle. As an example, utilities are a favorite during a recession because they tend to have reliable earnings and pay a consistent dividend. Conversely, energy companies tend to be popular during the peak of an economic cycle as both consumers and industry have a strong appetite for oil, coal, and/or natural gas.

In order to benefit from sector rotation, it’s not enough to know where we are in the economic cycle: recession or expansion. The stock market trades on future expectations, so to benefit from this strategy you need to estimate where the economy will be six to twelve months from now. Anticipating a recession would lead you to sell your energy companies and buy utilities. Acting in advance of the market” herd” means you theoretically will be buying at a lower price. When the recession environment becomes clear and investors rush to by defensive stocks like utilities, you would sell at a higher price. As an example, if you owned Utilities last year (2011) you earned an annual return of about 11% vs. 2% on the broad S&P 500.

Selecting the industries (or sectors) is the easy part. The hard part is predicting the economic cycle. Even that may not be enough to ensure you beat the market. It is very difficult to determine what stage of economic growth we’re at or when a recession will end. And the right timing is essential for the sector rotation strategy to outperform. Even if you are right about the timing of the economic cycle, you can still be wrong. Other events such as investor psychology, natural disasters, and/or government intervention can significantly change a normal market trajectory and disrupt your timing. However, under normal market cycles, effectively utilizing sector rotation has proven to provide superior returns.

As with any investment strategy, there are risks that should be measured against potential rewards. If your investment allocation dictates that you remain invested in equities, then utilizing sector rotation maybe a good strategy for you. Sector Rotation has been made easier with the advent of exchange trade funds (ETFs). These funds now allow you to buy a representation of an entire sector, like utilities, without buying all the individual companies that make up the index.

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